Winning in commoditized markets

The lowest-cost-producer model

The FABRICATOR June 2014
June 18, 2014
By: Dick Kallage

The lowest-cost-producer business model is simple. If you have the lowest costs and prices, you win. But this model can be ruthless, too.

Last month I postulated that many segments of the metal fabrication, stamping, and machining markets were taking on the characteristics of commoditization. This means that, from the buyer’s point of view, the services offered are insufficiently differentiated to justify buying at anything other than the lowest delivered price available in the buyer’s vendor space. In other words, for certain segments, price is king.

Granted, there are certain criteria that the supplier must meet to be in the buyer’s vendor space, though the weight put on the criteria can vary with the buyer. Regardless, most buyers want to be sure suppliers can produce the product either internally or through a sourcing network while meeting basic quality standards and lead-time demands. Quite often more than two or three suppliers can meet these criteria for a good portion of the buyer’s available work—in the buyer’s mind, at least. For this work, low price wins. The jobs are commoditized.

The Buyer of Commodities

Purchasing is judged by a purchased item’s realized price versus either a standard or estimate that is in the OEM’s product-cost model. The fact that this is an incomplete or even seriously flawed model for rating the purchasing function is a testament to the commodity mindset that exists at many OEMs.

The portion of the OEM’s product cost that is in purchased parts is increasing, following a general trend to focus on core competencies and outsource everything else. This increases available volume for the custom fabricator, which is good news, but with this also comes more pricing pressure. By outsourcing to custom fabricators, OEMs limit their own cost-reduction opportunities and transfer much of the cost-reduction responsibility to fabricators. More of the OEM’s product costs now are in sourced components, but they still need to reduce costs, so the realized price they get from their vendor base becomes a critical cost-reduction metric. With this model, pricing pressure is severe and never-ending.

Moreover, buyers now often have limited knowledge of the purchased product’s actual functional use and installed cost, and often zero knowledge of the total cost of ownership. This buyer really knows only one of the components: price. This is increasingly true if the purchase parts are viewed as neither highly specialized nor absolutely mission-critical. Unfortunately, this is where a lot of the metal processing space sits in the buyer’s mind.

In order to compete in this environment, the only successful strategy is the lowest-cost-producer model—as translated to mean the lowest-price producer. (This is different from the lowest installed cost or lowest total ownership cost model, which I will address next month.) This means that the supplier views its services as fundamentally undifferentiated in the buyer’s mind and has a sole focus on lowest cost and lowest price.

A Simple but Ruthless Business Model

The beauty of this model is that it guarantees success if a sufficient part of the realizable market is indeed undifferentiated. There can be only one lowest-cost producer in a given geographic region. If that’s you, you win.

To execute this model successfully, you must exhaustively examine and meet certain criteria:

  1. There must be a sufficient volume of work available that is purely price-driven.
  2. To profitably achieve the lowest cost and price, you must examine both direct and overhead costs. Both are volume-driven to a varying extent, though direct costs are less so. You must meet the criteria that above a certain minimum total volume the sum of the direct and overhead cost is the lowest among your competitors. You can trade direct costs for overhead costs (such as through automation), but you must pay serious attention to both.
  3. You must have access to capital to economically use automation and machines that replace skilled, high-cost labor with labor that is less skilled and thus less expensive.
  4. You must be able to continue to upgrade or replace these machines ahead of the competition.
  5. Your nonproduct services must be standardized, inexpensive, and highly limited. You can’t afford to tailor your model to every customer.
  6. You must focus only on parts or assemblies that fit your scheme. Deviations from this tend to lead to serious cost creep, which confounds the model.
  7. You must be acutely aware of probable competitive moves into your space and act aggressively to counter them before they actually happen.

What Can Go Awry?

Meeting these criteria over the long term is not easy. That’s why the lowest-cost producer of a commodity can change so often. Let’s take a look at why things can go wrong.

First comes the issue of volume. If the commoditized available volume (price only with basic quality and delivery) isn’t realized, the cost model changes unfavorably. This is because the model typically replaces variable direct labor costs with overhead (machine) costs. The economics are directly dependent upon volume. You simply must meet your worst-case available profitable volumes.

Unfortunately, this is not really in your control if the overall economy goes south like it did in 2008 and 2009. By the way, volume is behind the M&A “rollups” that go in and out of style—that is, buying smaller companies, combining them into one or as a self-supporting network to increase total volume while reducing and leveraging existing overhead.

The next problem has to do with costs. Costs can rise because meeting individual customer service or quality demands leads to relatively expensive activities not fully covered by the price. Such nonstandard activities are the enemy of this lowest-cost strategy for commodity products.

Costs also can rise by taking jobs outside your sweet spot in terms of volume, complexity, required everyday skills and capabilities, or standard flow patterns. This is very difficult to manage. Buyers often think that if you offer the lowest price in one segment, you should have the lowest price in all relevant segments, even though those jobs are not economical for you.

Employee turnover can also be a problem. To keep costs low, companies with this business model tend to keep wages and salaries low. Managing turnover and training costs can be difficult, especially when the economy is strong.

Moreover, if the competition finds a better, more cost-effective way to run their businesses, they can lower this minimum volume and still be successful. For example, companies that have adopted and realized lean concepts in practice will change this cost and service model significantly.

Finally, there’s the intensity and availability of capital. Lowest-cost producers typically have the highest levels of machine sophistication and automation and need to stay that way. This requires available capital as well as sufficient and consistent returns on that capital. The lowest-cost-producer model is predicated on volume. If that volume often misses the minimum or is below the minimum for extended periods (such as during a recession), the returns suffer, and further capital availability may become problematic.

If you are going to choose this lowest-cost-producer model, you first must closely examine the criteria and the likelihood of the strategy going awry. It is a simple model in theory, but one in which only one company in a geographic area and at a given time can exist. If you adopt it, understand that being in second place is no fun. It is disastrous.

Alternative Models

Think about these questions: Are there more than two competitors in your space that can do what you do for your largest customer? If so, what is your “win” percentage, or share, against them? What are your economically and market-proven differentiators? Are they recognized by your key buyers? Do they pay for them? Do you know the cost of ownership or total installed cost of your products and services at your top customers? Do your customers know? Do they even know the cost components?

Most custom fabricators, stampers, and machine shops seem to touch on, often a bit awkwardly, the low-cost-producer strategy. They also touch on a differentiation strategy. This model can be based on lowest installed cost or total cost of ownership; the two have a few common features, but are different at their core. I believe that a company must focus on one or the other to achieve good results—or even to survive.

Next month I’ll examine the strategies of differentiation and what you need to do to make the word “differentiated” actually mean “successfully differentiated.”

Dick Kallage was a management consultant to the metal fabricating industry. Kallage was the author of The FABRICATOR's "Improvement Insights" column from May 2012 to March 2016.

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The FABRICATOR is North America's leading magazine for the metal forming and fabricating industry. The magazine delivers the news, technical articles, and case histories that enable fabricators to do their jobs more efficiently. The FABRICATOR has served the industry since 1971.

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